Wednesday, March 12, 2008

• Canadian bank stocks continue to be under selling pressure as the credit crunch grind enters its eighth straight month and still counting. This prolonged period of credit market uncertainty has shaken investors' confidence particularly in the ability of the regulators and the Federal Reserve to deal with the current crisis and the possibility of a deep economic recession.

• The bank index declined 13% in 2007 representing only the fourth time in nearly fifty years where the bank index has declined 10% or more. The last time the bank index was down more than 10% was 1990 and the time before that was 1981. The bank index has increased more than 20% in a year, 15 times over the same period.

• The bank index has declined 12% year-to-date in 2008 with the overall market down 6%. Sentiment and fear are dominating bank stock prices.

• The sell-off in bank stocks has resulted in unprecedented valuations against bond yields with P/E multiples back to levels not seen since the Asia crisis. Bank dividend yields relative to bond yields are 133% or 7.0 standard deviations above the mean, a record level by a wide margin. Bank dividend payout ratios are 44% slightly above the historical mean of 38% - 42%. The market is discounting a dividend cut and we strongly believe that dividends will not only be maintained but will continue to grow at an 8%-12% rate over the next five years with some slowdown in dividend growth in 2008.

Solid Operating Earnings - Writedowns Modest

• The bank group incurred modest writedowns for the second straight quarter as it marks-to-market its trading positions and security holding for the major price declines in the credit markets and counterparty risk.

• Banks operating earnings in the first quarter were very solid with a modest 2% decline from the record quarter a year earlier, slightly better than expected. ROE remained extremely high at 21.9%.

• Writedowns in the quarter were very modest except for CM and BMO. TD was the only bank to increase its dividend with a 4% increase.

• Operating earnings year-over-year comparisons are difficult versus a record quarter a year earlier due to the 16% appreciation in the C$, higher loan losses, lower net interest margin and the very difficult capital market environment.

• Reported earnings fully loaded declined 57% year over year including CM's and BMO's large writedowns. ROE on this basis was 10.2%. If we exclude CM, reported earnings declined 14% with 17.9% ROE. If we exclude CM and BMO reported earnings declined 12% with ROE remaining high at 19.8%.

Market Capitalization Decline Extreme vs. Writedowns

• The after-tax writedowns in the first quarter totalled $2.9 billion with $2.5 billion concentrated in CM ($2.2 billion) and BMO ($324 million) with writedowns equal to 3.1 and 0.5 quarters of earnings respectively. TD had no writedowns again for the second straight quarter with NA, and RY writedowns modest at 0.06 and 0.13 of quarterly earnings respectively (exhibit 1).

• Canadian banks' total writedowns including BMO's natural gas trading losses now stand at $4.7 billion after-tax which represents approximately one quarter of bank group earnings, with these losses concentrated in CM and to a lesser extent BMO.

• Bank stocks have sold off through the credit crisis with market capitalization declining a cumulative $76 billion or 28% from the highs. The market capitalization decline is 16.2x the writedowns to date or 29.5x excluding CM. This ratio is extremely high and is unprecedented. The ratio in the large LDC writedown years of 1987 through 1989 was 1.8x and 2.3x during the large commercial real estate loan losses booked from 1992 through 1994.

• The three banks TD and RY who have modest or no write downs have also seen a major decline in market capitalization. TD has had no writedowns but its market capitalization has declined by $11 billion. RY market capitalization has declined by $20 billion on cumulative after-tax write downs of $347 million.

• If we use CM and NA as a benchmark in terms of market capitalization decline in relation to writedowns and use the 6x multiple we reverse engineer future writedowns that the market is discounting in bank share prices (exhibit 2). Based on this methodology the market is discounting future losses for bank group of $12.3 billion or $8.0 billion after tax which does not seem feasible. The high quality Canadian Banks have suffered severe share price contagion as these future losses seem extremely unlikely even in this major credit crisis.

Strong Fundamentals - High Profitability & Capital Levels

• Canadian Banks continue to maintain large capital positions especially relative to global competitors with profitability remaining near record highs with ROE in the 20% range. Canadian banks' exposure to the high risk asset classes remains relatively low with CM, BMO and NA being the exceptions. CM, BMO and NA exposure remain manageable. We expect bank earnings to remain relatively resilient through a recession with dividends safe.

• Banks have grown their earnings at 15% per annum for five straight years with 2008 earnings expected to be a pause before growth starts again beginning in the fourth quarter of 2008. We expect a strong rebound in earnings momentum in the second half of 2008 and 2009.

P/E Divergence Favours TD and RY

• Our stock selection continues to favour TD and RY with their high revenue growth, high reinvestment, lower earnings dependency from higher risk areas and strength of their retail and wealth management platforms.

• Individual bank P/E divergence has finally occurred after the group was trading at an abnormal narrow P/E spread (convergence). The P/E multiples have diverged above the historical mean, however the divergence can be extremely wide for a period. Individual bank relative P/E multiples can decline to the 70% to 78% relative range. BMO's relative P/E multiple historical mean is 93% with one standard deviation below the mean at 78%.

• Our view is that Canadian banks have solid balance sheets and strong underlying earnings and will be able to weather the prolonged and lingering credit crunch. As fear subsides, share prices should move up sharply. We continue to recommend aggressively buying banks at these levels.

• The current meltdown we believe is a tremendous buying opportunity and we would be at maximum possible weighting in the bank group with a focus on the high quality names: TD, and RY.

• Best buying opportunity in decades.

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RBC Capital Markets, 11 March 2008

We believe that a price to book approach to valuations is now more appropriate than P/E for bank stocks given the deteriorating economic and credit markets environment, and decreasing confidence in our earnings forecasts. We have reduced our 12-month target prices as a result.

• The banks traded at an average 1.65x book at the last trough (fall of 2002), which coincided with rapidly rising loan losses and difficult equity markets; well below the current 2.0x P/B median.

• We are using an average 1.8x P/B multiple to derive our price targets, to reflect lower risk free rates than back in 2002.

• We are using lower P/BV multiples relative to expected ROEs for banks we view as having higher "tail risk": NA, if the Montreal Accord fails; BMO, if off-balance sheet exposures lead to the bank raising equity; and CIBC, if the outlook for financial guarantors worsens.

• Canadian banks have traded at lower multiples in the the mid and early 1990s (1.0x – 1.2x book) but we believe trough multiples should be higher in this cycle as banks are less exposed to business lending, they have more exposure to wealth management, they have higher capitalization ratios, and risk free rates are lower.

• Our 12-month targets suggest median returns of 10% from holding bank shares in the next 12-months (including dividends). If we apply our target multiples to the current book value (as opposed to estimated book values 12 months from now), it suggests about 8% of potential near term downside in share prices.

• TD and RY remain our favourite bank stocks. These banks have stronger domestic retail franchises, and we believe that the larger risk exposures they have are more manageable than those at BMO and NA, our Underperform-rated bank stocks.

• Our 2008 earnings estimates have been below targets established by management teams since the year started, and we continue to believe that, even on a core basis, growth will be well below the rate of recent years. Furthermore, our GAAP earnings estimates are lower than our core earnings estimates, reflecting writedowns already seen and our expectations for more to come.

• The industry's Q1/08 core cash EPS declined at a median 2% versus Q1/07. On a GAAP basis, the EPS decline was 18%.

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Financial Post, Duncan Mavin, 12 March 2008

There will be more bumps along the road for Canada’s big banks, but a year from now their stock prices should mostly be trading higher on the back of modest earnings growth, said TD Newcrest analyst Jason Bilodeau in a note.

The global downturn in financial stocks, further credit market problems, and the worsening U.S. economy all overshadowed recent first quarter bank earnings, that were mildly disappointing, the TD analyst said.

But the banks are “fundamentally sound and well positioned businesses.” While the market remains sensitive to any potential exposures and negative headlines, the big banks will likely turn in higher earnings in 2008 compared to 2007, and their share prices should rise as a result, Mr. Bilodeau said.

Bank of Nova Scotia is TD’s top pick in the sector, in part because it has lower exposure to those risky areas than some of its competitors. TD has a “Buy” rating on Scotiabank, with a $56.00 target price.

Canadian Imperial Bank of Commerce and National Bank are also rated a “Buy” thanks to depressed stock prices that offer good value, according to TD.

Bank of Montreal is the negative outlier, because of higher than expected domestic retail banking costs, growing uncertainty around the bank’s credit crunch exposures, and higher loan losses.

“The most disappointing recent developments have occurred at BMO, and it remains the bank with the most uncertainty,” Mr. Bilodeau said. TD has a “Hold” rating on BMO, with a $53.00 target for BMO stock.